Arcane Topics in Economics and Philosophy, Interspersed with Various Distractions

October 28, 2011

If This is the Best Case They Can Make for Keynesianism...

Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed, relative to what could have happened — an acrimonious failure to agree on anything — the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States.

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed.

Krugman is conflating two quite different ideas here: (a) that the government (or the central bank) has to bail out banks to prevent a collapse of the financial system, and (b) that most governments need to retrench right now. Not only are the two ideas quite separable-- the government could bail out the banks and increase spending; or it could do neither-- but if anything, they are philosophically opposed. A comprehensive interventionist might advocate both; a libertarian would support neither. TARP is at this point not, I think, especially controversial among economists, so it's interesting that Krugman stakes out an anti-TARP position here. I'm glad of it: I think the anti-TARP view deserves more of a hearing than it has gotten. But how he would justify conflating TARP and austerity, I have no idea.

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.

Some economists weren’t convinced. One caustic critic referred to claims about the expansionary effects of austerity as amounting to belief in the “confidence fairy.” O.K., that was me.

But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank, which last year urged all European governments — not just those in fiscal distress — to engage in “fiscal consolidation.”

And when David Cameron became Britain’s prime minster last year, he immediately embarked on a program of spending cuts in the belief that this would actually boost the economy — a decision that was greeted with fawning praise by many American pundits.

Now, however, the results are in, and the picture isn’t pretty.

This is ridiculous. First, one distinction which it's essential to make is that between (a) countries that could have borrowed more, such as the United States, at least in the short run, or Germany; and (b) countries that lost access to financing or were on the verge of doing so, like Greece, Italy, Portugal, Spain, and Ireland. The latter were compelled to adopt austerity, not on their own terms but on those imposed by the markets, and the sovereign debt crisis hurt them in other ways too. The former had flexibility to design austerity in the way that would do them the least harm. So it's fair to use the example of Britain, but not Greece, Latvia, etc.

Second, the results are certainly not in-- yet. The European debt crisis seems to have been resolved, finally, but only just. There's been no time for it to take effect. And in general, austerity is a policy oriented towards the longer term. One doesn't expect it to help over the long term, but over three, five, ten years. In the East Asian crisis of 1998, austerity was pursued, and the recession was very deep and painful; but there was a strong rebound a couple of years later; in Japan after the crash of 1989, Keynesian stimulus was pursued, and the recession became more or less permanent.

It would be much more reasonable to say that "the results are in" on the path that was taken in America, namely, not-austerity, but Keynesian stimulus, "and it ain't pretty." Stimulus has had more time to work. The European sovereign debt crisis is much less of an issue here. And Keynesian stimulus is supposed to work in the short run; that's the whole point. Of course, Krugman claims that America has pursued austerity, but that just underscores the uselessness of this conceptual framework. With deficit spending at 10% of GDP for three years, this is as Keynesian a fiscal policy as we've had in decades. If we were deficit-spending 20% of GDP and it didn't work, the Keynesians could always say, hey, it should have been 30%. Of course, the Keynesians can also deny that it didn't work: they can say it did work, because things would have been even worse. If they were worse, they can say they would have been even worse than that. If we were deficit-spending 20% and unemployment were 15% instead of 9%, well, they could say that if we had been deficit-spending only 10% of GDP, unemployment would have been 20%. Why they expect anyone should believe their counter-factuals when none of them foresaw the crisis is a mystery. More conservative, free-marketeer, rational-expectations type economists are more epistemically modest. All we know is that the economy has a natural tendency towards full employment, and the best bet is that if policy had been neutral (admittedly that's hard to define) it would probably have reverted to trend (admittedly that's also hard to define) in a few years. By that standard, Keynesian stimulus seems to have made things worse, and certainly hasn't helped much; and the marginal effect of Keynesian stimulus would probably have been even more harmful, since the marginal benefit of just about anything falls, and the marginal cost rises, as you get more of it. But that's just the best guess.

Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared.

Maybe the most telling thing is what now passes for a success story. A few months ago various pundits began hailing the achievements of Latvia, which in the aftermath of a terrible recession, nonetheless, managed to reduce its budget deficit and convince markets that it was fiscally sound. That was, indeed, impressive, but it came at the cost of 16 percent unemployment and an economy that, while finally growing, is still 18 percent smaller than it was before the crisis.

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different.

If you’ve been reading accounts of the financial crisis, or watching film treatments like the excellent “Inside Job,” you know that Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

"Iceland let the banks go bust and expanded its social safety net." OK. But far more importantly, to-the-exclusion-of-everything-else importantly, Iceland has a floating currency and could devalue. Real wages could fall. For a tiny economy like Iceland's, trade is crucial. We always knew that improving competitiveness by devaluation can help a lot in a crisis.The East Asians did it in 1998, too. That's monetarism, not Keynesianism.

One supposes Krugman would use the best available arguments in favor of "the path not taken." If this is it, I was right to be dismissive.

Comments

It doesn't seem to me that he's defending Keynesianism here so much as attacking policies that advantage "job creators" as an economic cure. The whole thrust of his argument is that the financial sector got help and the proletariat or whatever didn't.

It's a stupid article. Iceland isn't at all comparable, because they essentially defaulted. Heck I sort of think Greece should have defaulted and fallen out of the Euro - at least, the Economist has made some pretty good arguments in that direction. The US can't default; the closest we can get is rounds of QE. Further, it seems pretty clear to me that we didn't really lose any money on TARP, and indeed I think it's relatively uncontroversial that "the 99%" benefited from it far from they lost. Krugman brings it up purely as a class warfare trope, slyly suggesting it was a handout to bankers without specifically saying that it was a bad idea or that it was costly.

Krugman can hardly be unaware of this, and so this is actually not a stupid article, it's an unusually intellectually-dishonest one. This is the kind of thing that makes it so hard for me to read the man on a consistent basis.

But neither is it appropriate to take this as "the best available arguments in favor of "the path not taken.""

In any case, I'm not at all convinced we really saw any stimulus in the aggregate: "With deficit spending at 10% of GDP for three years, this is as Keynesian a fiscal policy as we've had in decades" is potentially mistaken. At the same time the federal government was spending more, the state and local governments were spending much less. There are important differences between the two, but it seems very arguable that the "stimulus" really amounted to a mere aversion of sudden *contraction* in government spending.

Really, the only thing I think was plainly shown by recent economic results (since ~1980) is that lower taxes do not *by themselves* create a tremendous amount of growth or jobs unless you're coming down from a very high level. This doesn't refute any economic theory that's still well respected in 2011*, so I would regard economic history as less than dispositive on the major controversies in macro.

*It does refute a sort of supply-side economics popular amongst politicians, but I don't think that any serious economists have taken the position since Robert Mundell in the early 1980s, so I'm not sure that counts.

You're more positive about the benefits of TARP than I am, though I'm still retrospectively in favor of it, on balance. The problem is that TARP, and in general Bernanke's determination to save the banks, created tremendous moral hazard. And the result seems almost to have changed the banks so much that they're no longer doing their job. They hoard vast amounts of cash at the Fed rather than lending to business. Businesses, meanwhile, have hoarded enough of their own cash that a lot of them can invest without the banks' help. The cost of bailing out the banks almost seems-- this is tentative-- to have altered the nature of (and the incentives of) the banks so much as to make them much less valuable to the economy. If the banks had been allowed to go bust, one presumes that finance wouldn't have disappeared; savers and borrowers would have found some way to get in touch. In the internet age it might have been easier. And the Fed can take over the money-creation role of the banks pretty easily. I'm still with the consensus view, but on this point, I think Krugman's unorthodox view deserves respect.